Sunday, June 10, 2012

Banks Key to Recovery

With news of a possible bailout in Spain, bank bailouts are in the news again. I'm a big believer that banks are key to this recovery, but I'm skeptical that bailouts are actually helpful. That is, the best way to add a lack of focus to a bank is to make it even more beholden to 'the public'. A restructuring or default would be preferred, because then the pain is allocated to investors, and so new owners can start over without any baggage from prior favors from politicians and just maximize profits (there's a good reason to think this is what banks should be doing, but I understand many find that argument incomprehensible).

Anyway, I think one of my better ideas was in a post I wrote last year on Barrier Options and Business Cycles. The basic idea there was that if you looked at banks as not an option on a firm like in a Merton model, but as a barrier option on a firm, the vega actually becomes negative when the firm value is sufficiently low. This would mean banks go from taking on new projects to maximize equity value, to shedding projects.

Bank stocks are still well off their historical highs, and I think this has some relevance to our rather unusually soft recovery.

6 comments:

what "recovery", falken? do you want to go back to past "growth" like krugman? or the chinese?

this world is fubar because people like yourself, who should know better, are perpetuating the same old misunderstandings about banking. just like einstein's "God" comment.

please tell us what is the value to society in banks peddling mortgages to everyone with a pulse? why do banks exist to make residential mortgages in the first place? wouldn't all prices in the building industry adjust in the absence of this "convenience"?

did you know air travel decreased by 3/4 as % of household income in the last 50 years, while housing remained constant? the miracle of air travel vs. paying for shelter. just like medieval serfs.doesn't that strike you a little strange? I'm asking just because you didn't study at MIT like the other luminaries, who are absolutely convinced this is the way forward.

When I was a banker, we had 20% downpayments and credit scores above 600. Yet academics, regulators, legislators, community activists ... and bankers and investors thought that was unnecessary. They were wrong, but that's hardly a conspiracy.

Currently the government guarantees most mortgages below $300k, and I don't think that's been very helpful, because originators still face a lot of legal risk.

Actually the public is becoming more beholden to the banks as their bad debts either get swept under the government rug or they get “recapitalized” via (what amounts to) money printing and circular wire transfers. TBTF has expanded since 2008 and markets have been trained to ignore the seriously molested business cycle and instead lurch from one pronouncement from Central Planning to the next. The final act for this big, fat, unhealthy, substance abused white swan will not be pretty.

The huge role repo now plays in banking is underappreciated too. This is the transmission mechanism that caused the relatively small world sub-prime RRE lending to cripple the larger financial world. Check this “About Repo” piece out: http://repowatch.org/about-repo/

and I think (in this current context anyway) it will be harder to say: “No one knows how such small losses amplify in size and scope to create economy-wide downturns, because we have no good theory for it.”

European bank bailouts are allocating some pain to investors: equity holders get diluted as the bail out institution gets new issuance matching the public contribution.

It would be nice to default on senior bonds as well but this is very tricky because they typically rank the same as depositors, and defaulting on these would obviously not help. So it cannot be done without some form of emergency expropriation legislation (which I'd be surprised to see you support).

Also given entanglement it's not obvious that you could default on one major euro bank without having to take all of them into insolvency, that is a eurozone scale version of the icelandic scenario. That might help but is sufficiently tricky that nobody is in a hurry to press the nuclear button.

And in that scenario it's the US and UK who end up with (some of) the bill, which is a bit rude given how europe benefited from the AIG bailout and fed liquidity.